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Royce Funds Commentary - Chuck Royce on 2Q14: Fundamentals Reassert Their Importance

July 03, 2014 | About:

Since the May 2013 low for the 10-year Treasury, we have seen the market shift its focus to more fundamentally and financially stronger companies with attractive long-term prospects—qualities that we have always championed at Royce.

Chief Executive Officer and Portfolio Manager Chuck Royce explains why—after more than 40 years—he still feels bullish about active management in the small-cap space and offers his thoughts on equity market leadership so far in 2014, current valuations, and more.

Do you still feel bullish about active management in the small-cap space?

Absolutely. I am more bullish than ever about the prospects for active small-cap management.

We've obviously been biased in favor of active approaches here at Royce for many years, but I think over the last 14 months—dating back to the low for the 10-year Treasury in May of last year—we've reached a point at which active management in small-cap stocks simply makes more sense, at least for long-term investors.

Since that May 2013 low, company fundamentals are becoming more and more important as drivers of share price success.

Rather than invest in a small-cap index vehicle in which approximately 25% of the companies are losing money, I think it's smarter for investors to consider portfolios that look for well-run, financially strong companies with attractive long-term prospects.

Do you think the reign of low-quality stocks has come to an end, then?

For the most part, yes. I think we're entering a phase where quality companies—those with attractive characteristics such as strong balance sheets and high returns on invested capital—should begin to lead.

Certainly they led during the short correction that followed the 2014 small-cap high on March 4. They did not show as much strength when the market was recovering in May and June, but they did well enough to lead the small-cap pack from that early March high through the end of June.

I'd expect something like this pattern to continue at least through the end of the year as the market continues to adjust to the growing normalization of the economy, which I think will continue to expand and pick up momentum.

Why do you think mid- and large-cap stocks have outperformed small- and micro-cap stocks so far in 2014?

First, I think that mid-cap is an area with a number of wonderful, fundamentally sound businesses, and many have also demonstrated strong records of growth over the last few years.

The success of that asset class throughout the entire post-financial crisis cycle has not been a surprise to me. In fact, mid-caps have been an area of significant interest to us for years now.

Large-cap, of course, houses most of the globe's best-known, most stable companies. The small- and micro-cap spaces have, by contrast, high numbers of very speculative companies and are typically more volatile—sometimes much more so in the case of micro-caps. They've also enjoyed very strong runs over the last several years.

The three- and five-year annualized returns through the end of June for the Russell 2000 and Russell Microcap Indexes were terrific on an absolute basis. With equity investors acting more cautiously so far in 2014, the relative breather for small- and micro-cap stocks—and I don't think it's any more than a breather—was also not a surprise.

I should mention that the volatility in the small-cap market as a whole is something that we always try to use to our advantage. We've never seen it as a negative. It's helped to create some tremendous opportunities for us over the years.

Are you anticipating a correction before the end of the year?

I think it's hard to say—corrections can arrive at any time, of course, and it's been a while since we've seen anything significant.

The last downturn of more than 10% for the Russell 2000 occurred in the fall of 2012. We did experience a mild one earlier this year—the Russell 2000 declined 9.1% from its March 4 interim peak through May 15 of this year. Yet share prices recovered so quickly that it barely had time to register.

So while one could argue that we must be due for a decent-sized pullback, my sense is that we're more likely to see a smaller one in the 5-10% range. This is against the backdrop of an economy that looks poised for more rapid growth, a Fed that continues to taper at a healthy clip, and an interest-rate environment in which a steady rate of increase is much more of a "when" than an "if."

All of this is creating a more historically familiar set of conditions for stocks and for investors, so I'm fairly bullish. I could see the second half of the year being pretty similar to the first in terms of the overall returns for stocks.

Valuations on the whole are high, but there are still enough opportunities out there to keep returns in positive territory through the end of 2014.

Chuck Royce is Chief Executive Officer and a Portfolio Manager of Royce & Associates, LLC, investment adviser to The Royce Funds. Mr. Royce's thoughts in this interview concerning the stock market reflect his opinions and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.

The Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. Russell 2000 Index is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The Russell Microcap Index includes 1,000 of the smallest securities in the small-cap Russell 2000 Index, along with the next smallest eligible securities as determined by Russell. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.


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